In the previous articles we have understood what Full Capital Account Convertibility is and delved into few of the factors that determine Full Capital Account Convertibility (FCAC) approach is feasible or not. We will try to understand the effect of FCAC using the South East Asian crisis and its adoption.
The Asian Crisis of 1997-98 originated from Thailand. The Baht (Thai currency) was at that time pegged with US Dollar. As dollar appreciated, so did Baht, exports decreased, export competitiveness also reduced, leading to increased current account deficit and trade deficit. Thailand was heavily reliant on foreign debt with its huge CAD being dependent on foreign investment to stay afloat. Thus there was an increased forex risk.
As US increased its domestic interest rate, the investors started investing more in the US. It led to capital flight. Forex reserves rapidly depleted, and the Thai economy tumble down. Thai government decided to dissociate Baht from the US currency and floated Baht. Concurrently, the export growth in Thailand slowed down visibly.
Combination of these factors led to heavy demand for the foreign currency, causing a downward pressure on Baht. Asset prices also decreased. As asset prices fell, there was heavy default on debt obligations. Credit withdrawal started.
This crisis spread to other countries as a contagion effect. The exchange markets were flooded with the crisis currencies as there were few takers. It created a depreciative pressure on the exchange rate. To prevent currency depreciation, the governments were forced to hike interest rates and intervene in forex markets, buying the domestic currencies with their forex reserves. However, an artificially high interest rate adversely affected domestic investment, which spread to GDP, which declined, and eventually economies crashed.
In this backdrop, the most vicious argument offered by the opponents of FCAC had been the role of free currency convertibility. In the absence of any capital control, no restrictions were kept on capital outflow, and thus the herd behavior of investor led to economic crash of the entire region.
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